China Small Caps: Whom Can You Trust?

What if I told you that you could buy stock in a fast-growing company in one of the world's top growth markets at a price-to-earnings ratio of less than eight? In fact, what if I told you that you could buy loads of stocks that match this description? Sounds too good to be true, right?

It just may be.

Small-cap Chinese stocks, particularly those that have hit the U.S. markets by way of reverse-merger transactions (where an operating business in China buys a public shell company in the U.S.) have faced a storm of Katrina proportions as short-sellers have pummeled them with accusations of fraud. A great many Chinese small caps now trade at multiples that would normally make a value investor drool, but investors in the sector are so starry-eyed from the beating they've taken that they don't even know which way is up.

Liar, liar, pants on fireA rundown of all of the Chinese companies that have come under fire could fill an entire article. Heck, if we got into the details we could probably fill a book. But to give a taste of what's been racking this sector, here are a few of the better-known instances.

The company came under serious attack from multiple short-sellers claiming fraud. In apparent confirmation, the company's auditor cut ties and its CFO resigned. Trading in the stock has been halted since March 14.

(50%)

RINO International

Industrial environment equipment

Short-seller Muddy Waters claimed wide-reaching fraud at the company, most notably significant inflation of financials. The stock has been delisted from the Nasdaq, and management has been very quiet as far as addressing the allegations.

I could go on (and on and on) with more examples, but you get the idea.

It's important to note, however, that these situations are far from cookie-cutter. In the cases of RINO and China MediaExpress, for instance, the evidence available and the tepid response from the management teams make it seem likely that the only news out of the companies is likely to be bad news. With Yongye and Advanced Battery, on the other hand, there has been a much stronger response from the respective management teams and the detractors' evidence hasn't been as damning.

Whom do you trust?I've had my own concerns with small-cap Chinese companies. To begin with, any company -- Chinese or not -- that comes to the market via a reverse-merger transaction should raise at least a yellow flag for investors. Furthermore, the cash flow dynamics of RINO, Yongye, and China Security & Surveillance (NYSE: CSR) put them all on my short radar last summer.

Earlier this year, I was still skeptical, but I thought that investors who were adamant about tiptoeing through the minefield could protect themselves by looking for certain things -- including a major auditor.

Today, I'm far less convinced about that latter point. China MediaExpress had been audited by Deloitte Touche Tohmatsu while China Agritech (Nasdaq: CAGC) -- which has faced troublesome questions of its own -- dismissed Ernst & Young Hua Ming as its auditor. Over the past weekend, I discussed the issue with a contact that works at a major global investment firm, and he said that they have lost faith in all auditors in China -- big name or not -- and now always send their own people over to audit any company they plan to invest in.

Fight or flight?Despite my broad skepticism, it also seems to me that it's getting a little too easy for anyone to sell shares of a Chinese stock short, slap together a research-company name with a veneer of professionalism (or not), and send the shorted stock reeling by raising questions about its business.

Are all Chinese small caps fraudulent? Considering that Donald Trump may be a presidential candidate, I guess anything is possible, but I doubt it. So the million-dollar question is how can we figure out which companies aren't going to end up dropping napalm on our portfolios.

And the answer is really pretty simple: Get an accounting degree (if you don't already have one), fly to China, and convince the company to turn over their books to you so that you can review all of the numbers yourself. Visit the company's major operating centers and make sure that everything is as it should be. Finally, load up on a bunch of cool spy technology and revisit the major operating centers when they don't know you're coming and make sure everything is still as it should be.

Laughing? You should be. For most individual investors, the above plan is ridiculous because the cost of the diligence would be nowhere near justified by the likely amount of your investment.

I think there are two potential approaches that could make more sense for individual investors considering Chinese small caps.

1. Don't bother. There are thousands of stocks out there and plenty where there's little, if any, concern that the company is massively fraudulent. I've noted on a number of occasions that large-cap stocks look attractive, and we don't have to wonder whether a company like Intel is actually selling the products it says it is.

2. Create a basket. Going back to my assumption above that not every Chinese small cap is a fraud, an investor could put together a group of low-valued Chinese stocks and put a small investment in each. The advantage of this is that you face less risk from any specific company turning out to be smoke and mirrors, while you can still potentially benefit as the space shakes out and investors revalue the real companies at more reasonable multiples.

If you're considering option two, you'd be well advised to read all that you can on the space so you can fill your basket with the companies that appear least likely to be fraudulent. To do this, just start adding the stocks you're interested in to your watchlist and we'll make sure you get the news and reports you need to keep up to speed. You can add any of the stocks above by clicking the plus sign or you can start a fresh watchlist and add any tickers you want.

Comments from our Foolish Readers

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The question comes down to: can you perform adequate due diligence on Chinese small caps. At a minimum, this involves analysis of regulatory filings and the audited financials. But if these are not reliable, the only option is the one (somewhat laughably) mentioned in the article: going there and doing your own DD. It's no joke.

I have been invested in Chinese small caps for years but have now come to the conclusion that adequate DD (short of site visits) is not possible. In other words, I give up.

Even if the companies are not fraudulent, arguing with The Market is not a good use of my time.

i just hope they keep scared for long enough for me to me hands on some moola and be awfully greedy and follow #2 above. I think this is a situation that john templeton would love to find himself in, he would buy them all.

if i didn't know allready that you are a deceitful hipocritic short axxxx, i would waste my time to demostrate how idiotic is your argument.

but here is a clue sherlock in china they speak and write chinese and use the 250000 caracter of the chinese language, this is not for you but for the poor souls you succed on confusing with your propaganda.

obviously you do not know the chinese caracter for either yongye or shengmintzu and obviuosly you did not do your searches with it as obviously you did not even do the regular google search and if you did it is not only chinese which you do not know how to write nd read but english as well. cause google does give me search results

I've come up with a method to find relatively safe Chinese small-caps. Nothing is ever 100% safe, but I feel confident with the three recommendations that I have made... take a look at my latest blog post if you're interested.

One key point is to look at short interest. People don't do this enough. If short interest has been rising rapidly, and is over 10% of the float, then there is a good chance of someone putting out a negative report on that company.

Also, I disagree with the idea of having a basket of stocks. I tried this and it didn't work. The problem is that the entire sector is getting dragged down, and no Chinese RTO is safe. Even stocks like SUTR or CCCL, which have not been accused of fraud at all, are still getting hammered.

you do not sound legit brother mesayng you are a wolf dressing up as a lamb, disprove me if you can, disclose evidences for all your statement and explain why you'd care to share your wast experience with us poor fools

Anybody who wants to invest has to trust resources unless you actually know the company personally. Some are going to turn out to be frauds, and an uncomfortable percentage of these Chinese small-caps have proven to be. But then again, so did Enron, Tyco and a few others we all know about, and location didn't matter then.

The Fool's own Tim Hanson has been the loudest drum-beater for Yongye. He and his team visited not only the company but its distributors and customers on multiple occasions. CSR has had Wall Street coverage for years and demonstrates its products in the US. Its institutional ownership includes GE, Vanguard, Franklin and Templeton's legendary Mark Mobius. CSR's own CEO just offered to buy back every outstanding share for $6.50 (trading at $4.27 today).

Are YONG and CSR frauds? Not likely. But the the combination of less-than-brilliant quarterly numbers and the backwash from the fraudulent ones has taken them down anyway. There are lots of reasons for stocks to go down besides them being Chinese fakes.

That's true generally, but in the case of these Chinese smallcaps and particularly the RTOs, there seems to be a complete disregard for running a business on the up-and-up. So unfortunately, right now unless you're collecting the data first-hand, it's hard to trust what these companies are saying.

"Also, I disagree with the idea of having a basket of stocks. I tried this and it didn't work. The problem is that the entire sector is getting dragged down, and no Chinese RTO is safe. Even stocks like SUTR or CCCL, which have not been accused of fraud at all, are still getting hammered."

If you have a short timeframe (which it sounds like might be the case for you), then this will be true.

The idea though, is to buy the basket so that you will capture a bunch of the non-frauds. When this shakes out -- and eventually it will -- the market will revalue the company's that aren't fraudulent. In the basket you may end up with some bad apples, but you'd hopefully also end up with a bunch of stocks that will be marked way up when there's proof that they are actually earning the money they say they are.

It's not a short-term play though since you have to wait out the sector shake-out.

"Nowadays, even if its complicated and expensive to fly to China to check them out, I think with an online research a lot of information about a company can be gathered with simple googling."

The short response to that is, well, "no."

First of all, the question is whether or not information that you find is reliable. Many of the short researchers have shown that these companies will go to impressive lengths to fool investors -- including putting on an activity show when investors come to visit. (you have to commend their commitment to fraud).

On the flip side, you could have a perfectly legitimate company whose products, etc. won't show up in Google searches. Why? They're small companies and they sell their products in China. Do you think folks in China are talking about small U.S. companies that don't do business in their country?

I've owned Monsanto, Potash, Agrium, Mosaic, and I've own several Chinese Ags, like Feed, CGA, Agritech, othes. The big internationals first mentioned are good-uns to own for many years.

If one, as I, look for a small cap with special value-added products sold to a growing market that will always need finished goods (food), I've never found one with more bells & whistles than YONG. They have the track record of outstanding growth in revenue and profits; they even have had visits by Motley Fool personnel, twice. They have the international recognition (Harvard being one), Chinese gov't recognition (favorably tax ratings), and their mgt is quick to respond.

Yes, we have our Yong birthas, wanting to see customer lists and such. Did not Yong have to pay for one customer list to use to go after expanded business? Birthas expect Yong to "give" that list and others away as though they are no longer of value?

"Too good to be true" is often tossed at Yong. Hello. They are in China. Been booming and still a-booming over there. Yong is still small; won't be a billin $ company for another 2 or 3 years. They they get to a $2-5 billion entity growth will slow, just as it has for POT and othes. Hey! How about "Good to be true"? Why else are we into small caps? To enjoy the $ right upward.

Nice of Mr. Koppenheffer to put Yongye International (YONG) in the group with companies with some evidence of fraund. So far, there is none on Yongye. Further more, the writer of the article, to which Mr. Koppenheffer refers, adimittted using the following scientific principle: from the list of articles provided by Google Scholar he selected the first that supported his opinion. This 'scientific method' has a name: confirmation bias.

Regarding on the ground due diligence: there does exist investor services that are doing just that: Verification of SEC filings vs. China SAIC and SAT, site visits plus channel checks. And you can have these benefits with less than you pay for any single Fool advisor services. Yes, it is possible for an average 'dude' to invest on China small-cap - just with care.

"Nice of Mr. Koppenheffer to put Yongye International (YONG) in the group with companies with some evidence of fraund."

Wo wo wo.... first of all, I'm not sure what fraund is. But if it's similar to fraud, then I most certainly did not say that there's evidence of fraud at Yongye. (Think otherwise? Show me where...).

The table above shows a handful of the companies that have come under fire by short sellers / short research. If you want to assume guilt by association that's fine, but I'm not.

For the record, at this point I wouldn't personally make a bet on any single Chinese small cap. However, if I were to build a basket (and I may, which means I'll have to stop talking about these companies for a while), YONG would likely make the cut.

You just have to wonder about the Motley Fool. One day a writer pumps a stock, next day another slanders the same stock. Often this moves the stock, i.e. CSR down 12% today. People can make money. I would imagine that it is impossible for Motley Fool to monitor each writers' friends, relatives and associations - so the disclosures at the bottom could be far from complete.

It is shameful that the Motley Fool and others have no conscience about the harm they do to ordinary investors who have performed due diligence, when they publish articles written without any due diligence.

This fear-monger author starts with "Chinese", "too good to be true" and "reverse-merger transactions" so the intent of the article is immediately obvious. He mixes in a few known frauds with the innocents so all the sneer and smear seems rational. The article provides no facts (facts are numbers), just yards of innuendo.

Tens of facts need to be presented to make a reasonable case for or against a stock. Its a long time since I saw a Motley Fool article like that.

The authors only sensible comment is that it is wise to invest in a basket of stocks but doesn't everyone already know this? The author sites extremely low P/Es as a negative. How much brain power does it take to figure that the extremely low P/Es are due to months of short attacks, much worse than this one. Chinese reverse-merger stocks have been subjected to blanket bombing on a daily basis across all the financial commentary websites.

To end with a radical thought - maybe that basket of stocks should include the known frauds. They are highly shorted so there will plenty of buyers. Their new auditors will leave no rock unturned so their fraud days are over.

Except in the case of the fraudulent Chinese stocks where the numbers are fiction.

"To end with a radical thought - maybe that basket of stocks should include the known frauds. "

Good luck with that strategy.

@AlliceJ

"I'd like to see Tim Hansen's response to YONG's falling price. In fact, I think he owes us one. But that's just me."

Are you a Global Gains subscriber? If so, Tim keeps an ongoing dialog with subscribers about this and other Global Gains recommendations on the newsletter's discussion boards. If you're not a subscriber, you can check it out with a free trial here:

You've obviously brought your prejudices to this article and read from it what you want.

However, the basic idea here is that due to the fact that some of these companies have been completely fabricating numbers, customers, and business operations, the standard diligence that an individual investor would do may not be adequate.

Now you can call me a fear monger and choose to completely ignore what I have to say, or you can step back and consider why you believe you'll be able to figure out which of these companies are *for sure* not faking it. If you have such a strategy, I'd be very interested to hear it. Otherwise, I've presented two strategies (well, three if you consider the travel-to-China strategy) above -- I'm currently following #1 and am strongly considering #2.

I thought the basket idea was ridiculous before. Now it makes even less sense. If you enter now, you need to pick stocks that you're confident are legit, which means a ridiculous amount of due diligence. I do a lot of due diligence, and I can't do enough in this sector to be as certain I'd need to be. ANY INVESTMENT IN THIS SECTOR IS SPECULATION RIGHT NOW. It's not an accusation. It's fact. If you're comfortable with the risks involved, are able to manage your portfolio hourly, instead of weekly, there are HUGE gains there to be had. You have to devote a lot of time and energy to it in order to reap those gains.....a lot more than any other sector. You have to know that there are certain things that just can't be checked and you have to be able to be agile enough to react to news that will move your stock violently.

"If you enter now, you need to pick stocks that you're confident are legit"

Can you explain this logic to me?

My idea behind the basket is that it allows you to survive one or even multiple potential frauds among the group.

As an example, let's say you build a basket of 10 of these stocks and each has a current P/E of 5. Let's say four of the 10 prove to be complete and utter frauds and their stocks lose 100%. Investors get comfortable with the rest and their stocks are revalued with P/Es of 12 (still fairly low). Though you've had a handful of disasters in there, the return on the whole basket (excluding any impact from earnings growth) is 44%.

Investing in a single one of these stocks strikes me as highly speculative (and not something I'm particularly interested in). Investing in a basket, though I'd agree is still speculative, is much less so.

"you have to be able to be agile enough to react to news that will move your stock violently."

And to this I'd simply say, "no, you don't." If you're taking the approach of buying a basket and relying on the real companies to make up for losses on the, um, less real, then you don't want to trade in and out based on daily swings. Sure, you may want to try and cut your losses if a company is *proven* fraudulent, but in general the idea would be to take an "innocent until proven guilty" approach to short-side accusations.

There is a big difference between what you claim or think you are doing, and what you are actually doing. CSR closed down almost 13% after your article. That was your doing and you did it by generating fear by association (using bold font) with RINO, a known fraud. You implied CSR's cash flow dynamics were grounds for suspicion and shorting. As you know, there are many good reasons for different cash flow dynamics and it is rarely due to fraud.

Irresponsible articles like yours are fodder for the shorting networks, even if you are not associated with them.

I hope to make you more concious about the power of your words and the fear they can generate to deter buyers and start a shorting frenzy.

stuart, Heat looks llike a good buy now .. been holding the 3 dollars now.. and no fraud allegations as of yet hig institutional ownership compared to others and in the right energy sector... buy now!!

I'm going to go out on a limb and suggest that anybody that sold CSR today due solely to this article probably shouldn't be investing their own money. Though I'll also guess that the number is very close to zero.

Investors in Chinese stocks should be more focused on the businesses of the underlying companies and the veracity of the numbers, not on what's being said that might or might not be causing a one-day swing in the stock.

Gold, I don't find the piece especially unbalanced. What I'm concerned with is the context. The fool was on the ground and checked YONG out, and now that it's tanking they becomes neutral? So much like the Wall Street credit rating agencies.

"The fool was on the ground and checked YONG out, and now that it's tanking they becomes neutral?"

As noted in the disclosure:

"We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors."

There is no "Motley Fool" opinion on a stock. We're given leeway to call them as we individually see them. Investors that want an easy answer may not like this, but for those that want to see all sides of an investment and are interested in carefully considering the positives and negatives, it's much more useful than a parroted party-line.

When investing in China, select your 6-12 company basket to include only companies with large private equity and private money manager investment.

China Agritech for example has Carlyle and Glickenhaus on board.

While that is not a fool proof way to invest in every case, it puts the odds on your side because those boys do not screw up often and rarely get bamboozled.

In addition, stick with companies in industries with easier to identify trends. While I think Chanos is very wrong, and he admitted on CNBC today he might be about Chinese real estate, because the people seeking homes over the next few years exceeds the inventory by about 5x, I still stay away from direct construction plays. Rather, I'm mostly looking at companies that benefit from resource scarcity.

Kirkdyu, as one who has actively shopped for homes in China, I'd say Chanos is only partly wrong. There are areas with definite bubbles, and areas where demand is stronger than supply. As in the US, real estate is local.

In my opinion the real Chinese real estate crash potential is in commercial, not residential. I've seen office buildings standing empty even in the hottest areas, and there is none of the pent-up demand there is for residential. I think you're wise to avoid construction stocks.

What's the use of doing a DD? TMF did a DD on Yong. They went to China twice in search of the truth. They came back and gave a bullish report of Yong. But what is the price of Yong today? It was lasted traded at 4.76. From a high of over 9 in early November, 2010, it is now at under 5. TMF is long in Yong. If the expert can't win by being long in Chinese small caps, how can Dick, Tom and Harry fare well buying these small caps.

If you can't beat them, join them. And if you can't join them, leave them. This is the most sensible thing to do.

Do not put any money into any of these companies. If one can not trust the audits, they are worthless. I still sit on a pile of CCME from day trading. Didn't think that that was too risky - well, I was wrong.

It has been stated Chinese executives make no money (30k per year) compared to 20 million per year for some overpaid CEOs in US. Anyway, If chinese execs own the majority of their stock, why would they want to do anything to jeopardize the company (unless they were selling it under the table)? Can Chinese executives borrow money off of the stock they own in their company (like American execs can)? Does anyone know? I presume the answer is yes.